Jul 28, 2014

China: An Economic Blip?

By: Jens Erik Gould

Published: July 23, 2014

Earlier this year, the country long-heralded as an engine of global growth quickly became a source of collective woe. China’s enormous economy grew at its slowest pace in 18 months in the first quarter, leading economists to reduce their growth forecasts and equities investors to shift to a bearish stance. The slowdown proved short-lived, though, and growth in the Middle Kingdom picked up again in the second quarter. Still, a large swath of the market remains unconvinced: did the economy actually turn a corner or is the upswing merely a temporary blip?

Chinese policymakers can claim some credit for helping the economy shake off the blues. Moderate policy measures the government instituted in a bid to help the economy seem to have worked, including accelerating investment in railways and lowering corporate tax rates for small and medium-sized businesses. And a handful of economic indicators are flashing green, including factory activity, which expanded in June for the first time in six months, according to the HSBC/Markit Flash Manufacturing Purchasing Managers’ Index. Particularly impressive was the sub-index for new orders, which hit a 15-month high. Economists also stopped lowering their growth expectations: the average forecast currently sits at 7.3 percent for the year, not far from the government’s target of 7.5 percent.

But lurking beneath this apparent progress are persistent structural problems, according to Andrew Garthwaite, an equity strategist in Credit Suisse’s Investment Banking Division. His main source of concern is China’s property market. Real estate prices, which were on a constant upswing for nearly two years, finally reached untenable levels, and the average prices of new homes in 70 major cities fell 0.2 percent in May and then 0.5 percent in June. And the boom could easily turn into bust, as headlong construction threatens to create a marked excess in supply. Housing starts are 22 percent higher than the number of homes sold, while vacancy rates are at least 15 percent in urban areas, according to Credit Suisse. And China won’t be able to brush off a housing decline: real estate investment accounts for one-fifth of China’s gross domestic product and one-third of local government revenue.

There are other indicators that don’t sit well with economists either. The job offer to applications ratio, for example, has hit a new high. That points to a shortage of manual labor, which could hamper any renewed growth. Iron ore prices have fallen as well, suggesting a slowdown in steel production and infrastructure investment. And the portion of GDP accounted for by investment—currently at 46 percent—is the highest it’s ever been. That’s worrisome, Credit Suisse says, because investment-driven growth (as opposed to consumer-led) is causing excess capacity in sectors like automotive, as well as deflation in the producer price index, which measures the average change in the selling prices received by domestic producers.

And this all points to an inescapable reality for China: it can’t be Superman forever. It’s unlikely that even the long-term reforms the government is undertaking—from land reform to allowing markets a greater role in setting prices—can stop the law of large numbers from bringing the country’s growth rate down sooner or later. China could continue to defy traditional theories about how long developing economies can grow at a high rate; so far, it’s done just that. But China’s economy will be 80 percent larger in 2014 than it was in 2008, and the larger it becomes, the harder it will be to maintain a high rate of growth. Also, as the middle class grows and wages increase, China won’t have as much cheap manufacturing labor to prop up high growth rates.

Garthwaite believes that growth would have to dip below 5 percent for the slowdown to have a seriously negative impact on equities and global GDP. Since that’s not going to happen tomorrow, Credit Suisse still recommends a benchmark weighting to institutional investors despite concern about the real estate imbalance. In part, that’s because China has huge fiscal flexibility: while official figures show government debt to GDP at 56 percent of GDP, the country could conceivably finance a debt to GDP ratio of 170 percent. But things are only going to get more challenging from here. “The big problem in China is when growth really slows down meaningfully,” Garthwaite says. “Our view is optimistic, but in the medium term we’re nervous.”

Why Triple-Digit Oil Is the ‘New Normal’

By: Jens Erik Gould

Published: July 16, 2014

When the idea of high oil prices comes to mind, one quickly recalls the hot months of 2008, when crude prices of nearly $150 a barrel had summer drivers rethinking the cost vs. benefit equation of road trips. But one silver lining of the global financial crisis and economic slowdown was that it brought prices back down below $50 a barrel in November of that same year. And here we are again: Last month, the five-year rolling average price of Brent crude topped $100 a barrel for the first time ever. Worse yet, Credit Suisse energy commodity analyst Jan Stuart doesn’t think another reprieve is in the cards. He calls the current price level “a new normal.”

How did we get back here so quickly and why are prices likely to stay put?

On the demand side, it’s quite simple. Both the global economy as well as global population continue to grow, and along with them demand for fossil fuels. Global oil demand has fallen only two times in the past two decades: the height of the global financial crisis in 2008 and 2009. Global consumption should increase by 1.4 million barrels a day, or 1.5 percent, to a record 92.7 billion a day in 2014, according to the International Energy Agency, which raised its forecast in March as the economic recovery gained momentum.

For its part, supply is not keeping up with demand. While U.S. production has grown substantially thanks to shale drilling, the U.S. is the only major non-OPEC nation posting significant production increases. All-in, last year’s oil consumption grew by 1.4 million barrels a day, while production only increased 560,000 barrels a day, according to the BP Statistical Review of Energy.

As has been the case since the start, the main threat to oil supply is geopolitics. Increasing sectarian violence in Iraq, for example, has once again put the 150 billion barrels of proven oil reserves of OPEC’s second-largest producer into question, in the process helping to push the price of Brent to a high of $115.19 on June 19. Back in 2009, expectations were high: New investment by foreign oil companies was going to double Iraq’s output to 5 million barrels a day by 2013 and further increase it to 8 million by 2019. And that, in turn, would account for some 60 percent of OPEC’s overall production increase through decade’s end. Yet we’re nearly halfway through the decade and production is around 3.2 million barrels a day. Brent prices have dipped back below $110, and the current spasm of violence hasn’t reached the oil producing south, but companies including ExxonMobil and BP have begun evacuating employees, and investors are worried that continued violence could render even more modest production forecasts a pipe dream.

Iraq is just one example of many. The wave of political uprising exuberantly (and prematurely) coined the “Arab Spring” has left oil supply problems in its wake nearly everywhere it has rolled through. Protests that began last summer in Libya, which holds Africa’s largest reserves, cut output to around 350,000 barrels a day from the 1.4 million barrels a day the country was producing last year, although the country recently restarted production at its El Sharara field, which will hopefully bring between 300,000 and 340,000 barrels a day back online after a four-month strike by protesters. In South Sudan, fighting between the president and his former deputy has cut output by roughly one-third to around 160,000 barrels a day since December. Conflicts in Syria and Yemen have also cut output. “The instability in the Middle East and North Africa is so fundamental that it’s going to take a very long time for it to become a stable place for the oil industry,” says Stuart. In the meantime, production has fallen by a total of between 3 million and 3.5 million barrels a day since February 2011, according to Credit Suisse.

So let’s get back to this ‘new normal.’ Last month, Credit Suisse raised its forecast for average Brent prices in 2014 and 2015 to $110.64 and $102.50 from $107.03 and $97.50, respectively. And these things do not happen in a vacuum. Every $10 a barrel increase in oil prices reduces real U.S. income growth by as much as 0.4 percent, according to Credit Suisse estimates. “We are worried about the political events in the Middle East,” says James Sweeney, chief economist for Credit Suisse’s investment bank. “A meaningful shock in oil could really disturb a lot of our cyclical outlook.”

Photo: Iraqi laborers work at the Rumaila oil refinery near the city of Basra. (Courtesy of Associated Press)

Draghi Can’t Hold the Euro Down Much Longer

By: Ashley Kindergan

Published: May 16, 2014

Technically speaking, the European Central Bank did nothing at its monthly meeting last week. Despite plenty of discussion that May might finally have been the monthfor fresh monetary stimulus, policymakers not only left interest rates where they were, they also failed to offer up a quantitative easing program that many had hoped for. Instead, ECB President Mario Draghi did what he’s become quite expert at doing—he offered soothing assurances of preparedness. Such an approach has served him quite well to this point, but talk alone is unlikely to keep the markets at bay for much longer. Particularly where the euro is concerned: Cyclical indicators appear robust, the current account surplus is near a record high, and foreign investors are pouring money into European stocks. By all rights, the currency should be strengthening – and if the ECB continues to punt, it’s likely to start doing just that.

What, exactly, did Draghi say? He announced that the central bank’s Governing Council is “unanimous in its commitment” to use unconventional monetary tools such as QE to nudge inflation higher from 0.7 percent levels and toward the bank’s 2 percent target. Not only that, he also offered a time frame: maybe as soon as next month. The statement revealed a new sense of urgency from an institution that has been wary of taking action since its last rate cutin November 2013, despite stubbornly high unemployment and persistently low inflation. But whether he realized it or not, Draghi – the man who singlehandedly calmed panicked investors in 2012 by saying the central bank would do “whatever it takes” to keep the monetary union together – might have played his last remaining card in his attempts to keep the euro trading within a relatively tight range against the dollar.

Credit Suisse still doesn’t expect a quantitative easing announcement, but analysts say a further rate cut potentially combined with further liquidity announcements cannot be excluded. What could cause the ECB to act? Inflation. Or, more precisely, a lack thereof. Annual inflation rates haven’t topped 1 percent since September 2013, which suggests weak consumer demand, even if Draghi is correct that there is little imminent danger of deflation. But Credit Suisse says the central bank is likely to act if it is forced in June to revise its 2016 inflation forecast down from 1.5 percent.

One thing that might bring that about is further strength in the euro, which is up 1.5 percent against the dollar since a mid-February trough and 5.6 percent since last year. According to Credit Suisse foreign exchange strategists, if the euro keeps improving against the dollar — to, say, $1.44 compared to the current rate of $1.38 – it would likely push the 2016 inflation forecast meaningfully lower. That helps explain, at least in part, Draghi’s hint about a June stimulus, one result of which is that the euro has weakened slightly against the dollar since the ECB meeting. But Credit Suisse believes it would take an actual policy change to weaken the currency, since improving economic factors support a move in the opposite direction.

The euro zone experienced relatively strong year-over-year GDP growth of 0.5 percent in the first quarter, and both retail sales growth and the combined output of the services and manufacturing sectors hit three-year highs in March. Portugal, Ireland and Spain have all emerged on stronger footing from their bailouts over the last year, and Greece was even able to tap the international bond markets in April. Credit Suisse also expects global demand to pick up in the second half of the year, particularly in the United States, which should improve demand for European exports.

The euro faces upward pressure on two additional fronts. First, the euro zone posted a €21.9 billion ($30.1 billion) current account surplus in February, only a slight dip from a record-breaking €25.3 billion ($35 billion) surplus in January. Second, Credit Suisse’s foreign-exchange analysts note in a report entitled, “Stuck in a Moment,” foreign investors have been enthusiastic buyers of euro-denominated assets (particularly equities) since 2010, thanks to low interest rates and steady improvement in peripheral markets. The bank’s equities analysts see the EuroStoxx 50 index heading to 3,600 by the end of the year, 12 percent above current levels.

Until now, Draghi has been able to keep the euro contained simply by reminding markets that the central bank could ease further. But if he and the ECB continue to do nothing, dovish words alone won’t hold the euro back much longer.